402- treasury management.doc

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INFLATION - ITS IMPACT ON ECONOMIC GROWTH OF COUNTRIES

WITH SPECIAL REFERENCE TO INDIA

Subject: Treasury Risk Management402

Submitted to: V.Ramamurthy(Visiting faculty)NALSAR University of LawInstitute of Insurance & Risk Management

Submitted By: Swapnil SinghRoll No. FS11-017IInd Year , IVth SemesterMasters in Law Of Financial ServicesAnd Capital Markets

NALSAR University of law Institute of Insurance and Risk Management

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CONTENTS

CHAPTERS PAGE NUMBER

Inflation 2

How inflation is measured? 4

Causes of inflation 6

Effect of inflation 9

Methods to control 12

Other monetary phenomena 17

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CHAPTER I

INTRODUCTION

Inflation can be defined as a rise in the general price level and therefore a fall in the value of

money. Inflation occurs when the amount of buying power is higher than the output of goods and

services. Inflation also occurs when the amount of money exceeds the amount of goods and

services available. As to whether the fall in the value of money will affect the functions of money

depends on the degree of the fall. Basically, refers to an increase in the supply of currency or

credit relative to the availability of goods and services, resulting in higher prices.

Therefore, inflation can be measured in terms of percentages. The percentage increase in the price

index, as a rate per cent per unit of time, which is usually in years. The two basic price indexes

are used when measuring inflation, the producer price index (PPI) and the consumer price index

(CPI) which is also known as the cost of living index number.

Inflation is a key indicator of a country & provides important insight of the economy & sound

macro-economic policies. There is a consensus among many economist that a Positive

relationship usually exists between inflation & economic growth in the short run. A moderate

& Sable inflation not only helps in economic growth but also uplifts the poor fixed income

segment of the society unlike high price level that may create uncertainty hamper economic

growth.

Inflation can have positive and negativeeffects on an economy. Negative effects of inflation

include loss in stability in the real value of money and other monetary items over time;

uncertainty about future inflation may discourage investment and saving, and high inflation may

lead to shortages ofgoods if consumers begin hoarding out of concern that prices will increase in

the future. Positive effects include a mitigation of economic recessions, and debt reliefby

reducing the real level of debt.

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RESEARCH METHODOLOGY

The sources of data relied on include secondary sources. The materials used for this research

project includes, Articles and books. The research-methodology adopted is mainly Non-doctrinal

and descriptive.

Research Hypothesis

1. To investigate the impact of inflation on economic growth.

2. To find how inflation effect the living standard & purchasing power of society.

3. To find how inflation effect the business investment.

4. To examine how inflation usually leads to higher nominal interest rates.

Research Plan

The Research is divided into Headings and Sub-headings. The headings give the essence of the

particular topic and the sub-headings explain the topic in detail.

Research Scope and Limitation

The research scope is limited due to the research methodology adopted by the researcher.

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CHAPIER II

HOW INFLATION IS MEASURED

Inflation is normally given as a percentage and generally in years or in some instances quarterlyand is derived from the Consumer Price Index (CPI).

However, there are two main indices used to measure inflation. The first is the Consumer Price

Index, or the CPI. The CPI is a measure of the price of a set group of goods and services. The

"bundle," as the group is known, contains items such as food, clothing, gasoline, and even

computers. The amount of inflation is measured by the change in the cost of the bundle: if it costs

5% more to purchase the bundle than it did one year before, there has been a 5% annual rate of

inflation over that period based on the CPI. You will also often hear about the "Core Rate" or the

"Core CPI." There are certain items in the bundle used to measure the CPI that are extremely

volatile, such as gasoline prices. By eliminating the items that can significantly affect the cost of

the bundle (in either direction) on a month-to-month basis, the Core rate is thought to be a better

indicator of real inflation, the slow, but steady increase in the price of goods and services.

The second measure of inflation is the Producer Price Index, or the PPI. While the CPI indicates

the change in the purchasing power of a consumer, the PPI measures the change in the purchasing

power of the producers of those goods. The PPI measures how much producers of products are

getting on the wholesale level, i.e. the price at which a good is sold to other businesses before the

good is sold to a consumer. The PPI actually combines a series of smaller indices that cross many

industries and measure the prices for three types of goods: crude, intermediate and finished.

Generally, the markets are most concerned with the finished goods because these are a strong

indicator of what will happen with future CPI reports. The CPI is a more popular measure of

inflation than the PPI, but investors watch both closely.

TYPES OF INFLATION:

Subsequently, when either the prices of goods or services or the supply of money rises; this is

considered as inflation. Depending on the characteristics and the intensity of inflation, there are

several types, namely.

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Creeping inflation

Trotting inflation

Galloping inflation

Hyper inflation

When there is a general rise in prices at very low rates, which is usually between 2-4 percent

annually, this is known as creeping inflation.

Whereas, trotting inflation occurs when the percentage has risen from 5 to almost percent. At this

level it is a warning signal for most governments to take measures to avoid exceeding double-

digit figures.

Another type of inflation is the galloping inflation, where the rate of inflation is increasing at a

noticeable speed and at a remarkable rate, usually from 10-20 percent.

However, when the inflation rate rises to over 20% it is generally considered as hyper inflation

and at this stage it is almost uncontrollable because it increases more rapidly in such a little time

frame.

The main difference between the galloping and hyper inflation, is that hyperinflation occurs when

prices rise at any moment and there is no level to which the prices might rise.

During World War II certain countries experienced a hyperinflation, where the price index rose

from 1 to over 1,000,000,000 in Germany during January 1922 to November 1923.

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CHAPTER III

CAUSES OF INFLATION

Inflation comes in different forms and those at are familiar with the economic matters would

observe that there are trends in the way that prices are moving gradual and irregular in relation to

aggregate sections of the economy. This suggest that there is more than one factor that causes

inflation and as different sections of the economy develop it gives rise to different types

inflationary periods. The main causes of inflation are:

Demand-pull Inflation

Cost push Inflation

Monetary inflation

Structural inflation

Imported inflation

DEMAND-PULL INFLATION

Demand-pull inflation occurs when the consumers, businesses or the governments demand for

goods and services exceed the supply; therefore the cost of the item rises, unless supply is

perfectly elastic. Because we do not live in a perfect market supply is somewhat inelastic and the

supply of goods and services can only be increased if the factors of production are increased.

The increase in demand is created from in increase in other areas, such as the supply of money,

the increase of wages which would then give rise in disposable income, and once the consumers

have more disposal income this would lead to aggregate spending. As a result of the aggregate

spending there would also be an increase in demand for exports and possible hoarding and

profiteering from producers. The excessive demand, the prices of final goods and services would

be forced to increase and this increase gives rise to inflation.

COST-PUSH INFLATION

Cost-push inflation is caused by an increase in production costs. It is generally caused by an

increase in wages or an increase in the profit margins of the entrepreneurs.

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When wages are increased, this causes the business owner to in turn increase the price of final

goods and services which would be passed onto the consumers and the same consumers are also

the employees. As a result of the increase in prices for final goods and services the employees

realise that their income is insufficient to meet their standard of living because the basic cost of

living has increased. The trade unions then act as the mediator for the employees and negotiate

better wages and conditions of employment. If the negotiations are successful and the employees

are given the requested wage increase this would further affect the prices of goods and services

and invariably affected.

On the other hand, when firms attempt to increase their profit margins by making the prices more

responsive to supply of a good or service instead of the demand for that said good or service. This

is usually done regardless to the state of the economy. This can be seen in monopolisticeconomies where the firm is the only supplier or by entrepreneurs that are seeking a larger profit

for their own self interests.

MONETARY INFLATION

Monetary inflation occurs when there is an excessive supply of money. It is understood that the

government increases the money supply faster than the quantity of goods increases, which results

in inflation. Interestingly as the supply of goods increase the money supply has to increase or else

prices actually go down.

When a dollar is worth less because the supply of dollars has increased, all businesses are forced

to raise prices just to get the same value for their products.

STRUCTURAL INFLATION

Planned inflation that is caused by a government's monetary policy is called structural inflation.

This type of inflation is not caused by the excess of demand or supply but is built into an

economy due to the governments monetary policy.

In developed countries they are characterized by a lack of adequate resources like capital, foreign

exchange, land and infrastructure. Furthermore, over-population with the majority depending on

agriculture for their livelihood means that there is a fragmentation of the land holdings. There are

other institutional factors like land-ownership, technological backwardness and low rate of

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investment in agriculture. These features are typical of the developing economies. For example, in

developing country where the majority of the population live in the rural areas and depend on

agriculture and the government implements a new industry, some people get employment outside

the agricultural sector and settle down in urban areas. Because there might be an unequal

distribution of land ownership and tenancy, technological backwardness and low rates of

investments in agriculture inclusive of inadequate growth of the domestic supply of food which

corresponds with an increase in demand arising from increasing urbanization and population

prices increase.

Food being the key wage-good, an increase in its price tends to raise other prices as well.

Therefore, some economists consider food prices to be the major factor, which leads to inflation

in the developing economies.

IMPORTED INFLATION

Another type of inflation is imported inflation. This occurs when the inflation of goods and

services from foreign countries that are experiencing inflation are imported and the increase in

prices for that imported good or service will directly affect the cost of living. Another way

imported inflation can add to our inflation rate is when overseas firms increase their prices and we

pay more for our goods increasing our own inflation.

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CHAPTER IV

EFFECT OF INFLATION

Inflation can havepositive and negativeeffects on an economy. Negative effects of inflation

include loss in stability in the real value of money and other monetary items over time;

uncertainty about future inflation may discourage investment and saving, and high inflation may

lead to shortages ofgoods if consumers begin hoarding out of concern that prices will increase in

the future. Positive effects include a mitigation of economic recessions, and debt reliefby

reducing the real level of debt.

Most effects of inflation are negative, and can hurt individuals and companies alike, below are a

list of negative and positive effects of inflation:

NEGATIVE EFFECTS ARE:

Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and

other commodities creating shortages of the hoarded objects).

Distortion of relative prices (usually the prices of goods go higher, especially the prices of

commodities).

Increased risk - Higher uncertainties (uncertainties in business always exist, but withinflation risks are very high, because of the instability of prices).

Income diffusion effect (which is basically an operation of income redistribution).

Existing creditors will be hurt (because the value of the money they will receive from their

borrowers later will be lower than the money they gave before).

Fixed income recipients will be hurt (because while inflation increases, their incomedoesnt increase, and therefore their income will have less value over time).

Increased consumption ratio at the early stages of inflation (people will be consuming

more because money is more abundant and its value is not lowered yet).

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Lowers national saving (when there is a high inflation, saving money would mean

watching your cash decrease in value day after day, so people tend to spend the cash on

something else).

Illusions of making profits (companies will think they were making profits while in reality

theyre losing money if they dont take into consideration the inflation rate when

calculating profits).

Causes an increase in tax bracket (people will be taxed a higher percentage if their income

increases following an inflation increase).

Causes mal-investment (in inflation times, the data given about an investment is often

deceptive and unreliable, therefore causing losses in investments).

Causes business cycles (many companies will have to go out of business because of the

losses they incurred from inflation and its effects).

Currency debasement (which lowers the value of a currency, and sometimes cause a new

currency to be born)

Rising prices of imports (if the currency is debased, then its purchasing power in the

international market is lower).

"POSITIVE" EFFECTS OF INFLATION ARE:

It can benefit the inflators (those responsible for the inflation)

It be benefit early and first recipients of the inflated money (because the negative effects

of inflation are not there yet).

It can benefit the cartels (it benefits big cartels, destroys small sellers, and can cause price

control set by the cartels for their own benefits).

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It might relatively benefit borrowers who will have to pay the same amount of money they

borrowed (+ fixed interests), but the inflation could be higher than the interests, therefore

they will be paying less money back. (example, you borrowed $1000 in 2005 with a 5%

fixed interest rate and you paid it back in full in 2007, lets suppose the inflation rate for

2005, 2006 and 2007 has been 15%, you were charged %5 of interests, but in reality, you

were earning %10 of interests, because 15% (inflation rate) 5% (interests) = %10 profit,

which means you have paid only 70% of the real value in the 3 years.

Note: Banks are aware of this problem, and when inflation rises, their interest rates might

rise as well. So don't take out loans based on this information.

Many economists favor a low steady rate of inflation, low (as opposed to zero or negative)

inflation may reduce the severity of economic recessions by enabling the labor market to

adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents

monetary policy from stabilizing the economy. The task of keeping the rate of inflation

low and stable is usually given to monetary authorities. Generally, these monetary

authorities are the central banks that control the size of the money supply through the

setting of interest rates, through open market operations, and through the setting of

banking reserve requirements.

Tobin effect argues that: a moderate level of inflation can increase investment in an

economy leading to faster growth or at least higher steady state level of income. This is

due to the fact that inflation lowers the return on monetary assets relative to real assets,

such as physical capital. To avoid inflation, investors would switch from holding their

assets as money (or a similar, susceptible to inflation, form) to investing in real capital

projects.

The first three effects are only positive to a few elite, and therefore might not beconsidered positive by the general public.

CHAPTRT V

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METHODS TO CONTROL

A high inflation rate is undesirable because it has negative consequences. However, the remedy

for such inflation depends on the cause. Therefore, government must diagnose its causes before

implementing policies.

MONETARY POLICY

Inflation is primarily a monetary phenomenon. Hence, the most logical solution to check inflation

is to check the flow of money supply by devising appropriate monetary policy and carefully

implementing such measures. To control inflation, it is necessary to control total expenditures

because under conditions of full employment, increase in total expenditures will be reflected in a

general rise in prices, that is, inflation. Monetary policy is used to control inflation and is based

on the assumption that a rise in prices is due to excess of monetary demand for goods and services

by the consumers/households e because easy bank credit is available to them. Monetary policy,

thus, pertains to banking and credit availability of loans to firms and households, interest rates,

public debt and its management, and the monetary standard. Monetary management is aimed at

the commercial banking systems, and through this action, its effects are primarily felt in the

economy as a whole. By directly affecting the volume of cash reserves of the banks, can regulate

the supply of money and credit in the economy, thereby influencing the structure of interest ratesand the availability of credit. Both these, factors affect the components of aggregate demand and

the flow of expenditure in the economy.

The central banks monetary management methods, the devices for decreasing or increasing the

supply of money and credit for monetary stability is called monetary policy. Central banks

generally use the three quantitative measures to control the volume of credit in an economy,

namely:

1. Raising bank rates

2. Open market operations and

3. Variable reserve ratio

However, there are various limitations on the effective working of the quantitative measures of

credit control adapted by the central banks and, to that extent, monetary measures to control

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inflation are weakened. In fact, in controlling inflation moderate monetary measures, by

themselves, are relatively ineffective. On the other hand, drastic monetary measures are not good

for the economic system because they may easily send the economy into a decline.

In a developing economy there is always an increasing need for credit. Growth requires credit

expansion but to check inflation, there is need to contract credit. In such an encounter, the best

course is to resort to credit control, restricting the flow of credit into the unproductive, inflation-

infected sectors and speculative activities, and diversifying the flow of credit towards the most

desirable needs of productive and growth-inducing sector.

It should be noted that the impression that the rate of spending can be controlled rigorously by the

contraction of credit or money supply is wrong in the context of modern economic societies. In

modern community, tangible, wealth is typically represented by claims in the form of securities,

bonds, etc., or near moneys, as they are called. Such near moneys are highly liquid assets, and

they are very close to being money. They increase the general liquidity of the economy. In these

circumstances, it is not so simple to control the rate of spending or total outlays merely by

controlling the quantity of money. Thus, there is no immediate and direct relationship between

money supply and the price level, as is normally conceived by the traditional quantity theories.

When there is inflation in an economy, monetary restraints can, in conjunction with other

measures, play a useful role in controlling inflation.

FISCAL MEASURES

Fiscal policy is another type of budgetary policy in relation to taxation, public borrowing, and

public expenditure. To curve the effects of inflation and changes in the total expenditure, fiscal

measures would have to be implemented which involves an increase in taxation and decrease in

government spending. During inflationary periods the government is supposed to counteract an

increase in private spending. It can be cleared noted that during a period of full employment

inflation, the aggregate demand in relation to the limited supply of goods and services is reduced

to the extent that government expenditures are shortened.

Along with public expenditure, governments must simultaneously increase taxes that would

effectively reduce private expenditure, in an effect to minimise inflationary pressures. It is known

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that when more taxes are imposed, the size of the disposable income diminishes, also the

magnitude of the inflationary gap in regards to the availability of the supply of goods and

services.

In some instances, tax policy has been directed towards restricting demand without restricting

level of production. For example, excise duties or sales tax on various commodities may take

away the buying power from the consumer goods market without discouraging the level of

production. However, some economists point out that this is not a correct way of combating

inflation because it may lead to a regressive status within the economy.

As a result, this may lead to a further rise in prices of goods and services, and inflation can spread

from one sector of the economy to another and from one type of goods and services to another.

Therefore, a reduction in public expenditure, and an increase in taxes produces a cash surplus in

the budget. Keynes, however, suggested a programme of compulsory savings, such as deferred

pay as an anti-inflationary measure. Deferred pay indicates that the consumer defers a part of his

or her wages by buying savings bonds (which, of course, is a sort of public borrowing), which are

redeemable after a particular period of time, this is sometimes called forced savings.

Additionally, private savings have a strong disinflationary effect on the economy and an increase

in these is an important measure for controlling inflation. Government policy should therefore,

include devices for increasing savings. A strong savings drive reduces the spendable income of

the consumers, without any harmful effects of any kind that are associated with higher taxation.

Furthermore, the effects of a large deficit budget, which is mainly responsible for inflation, can be

partially offset by covering the deficit through public borrowings. It should be noted that it is only

government borrowing from non-bank lenders that has a disinflationary effect. In addition, public

debt may be managed in such a way that the supply of money in the country may be controlled.

The government should avoid paying back any of its past loans during inflationary periods, in

order to prevent an increase in the circulation of money. Anti-inflationary debt management also

includes cancellation of public debt held by the central bank out of a budgetary surplus.

Fiscal policy by itself may not be very effective in combating inflation; therefore a combination

of fiscal and monetary tools can work together in achieving the desired outcome.

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DIRECT MEASURES OF CONTROL

Direct controls refer to the regulatory measures undertaken to convert an open inflation into a

repressed one.

Such regulatory measures involve the use of direct control on prices and rationing of scarce

goods. The function of price control is a fix a legal ceiling, beyond which prices of particular

goods may not increase. When ceiling prices are fixed and enforced, it means prices are not

allowed to rise further and so, inflation is suppressed.

Under price control, producers cannot raise the price beyond a specified level, even though there

may be a pressure of excessive demand forcing it up. For example, during wartimes, price control

was used to suppress inflation.

In times of the severe scarcity of certain goods, particularly, food grains, government may have to

enforce rationing, along with price control. The main function of rationing is to divert

consumption from those commodities whose supply needs to be restricted for some special

reasons; such as, to make the commodity more available to a larger number of households.

Therefore, rationing becomes essential when necessities, such as food grains, are relatively

scarce. Rationing has the effect of limiting the variety of quantity of goods available for the good

cause of price stability and distributive impartiality. However, according to Keynes, rationing

involves a great deal of waste, both of resources and of employment.

Another control measure that was suggested is the control of wages as it often becomes necessary

in order to stop a wage-price spiral. During galloping inflation, it may be necessary to apply a

wage-profit freeze. Ceilings on wages and profits keep down disposable income and, therefore the

total effective demand for goods and services.

On the other hand, restrictions on imports may also help to increase supplies of essential

commodities and ease the inflationary pressure. However, this is possible only to a limited extent,

depending upon the balance of payments situation. Similarly, exports may also be reduced in an

effort to increase the availability of the domestic supply of essential commodities so that inflation

is eased. But a country with a deficit balance of payments cannot dare to cut exports and increase

imports, because the remedy will be worse than the disease itself.

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In overpopulated countries like India, it is also essential to check the growth of the population

through an effective family planning programme, because this will help in reducing the increasing

pressure on the general demand for goods and services. Again, the supply of real goods should be

increased by producing more. Without increasing production, inflation just cannot be controlled.

Some economists have even suggested indexing in order to minimise certain ill-effects of

inflation. Indexing refers to monetary corrections through periodic adjustments in money incomes

of the people and in the values of financial assets such as savings deposits, which are held by

them in relation to the degrees of price rise. Basically, if the annual price were to rise to 20%, the

money incomes and values of financial assets are enhanced by 20%, under the system of

indexing.

Indexing also saves the government from public wrath due to severe inflation persisting over a

long period. Critics, however, do not favour indexing, as it does not cure inflation but rather it

encourages living with inflation. Therefore, it is a highly discretionary method.

In general, monetary and fiscal controls may be used to repress excess demand but direct controls

can be more useful when they are applied to specific scarcity areas. As a result, anti-inflationary

policies should involve varied programmes and cannot exclusively depend on a particular type of

measure only.

CHAPTER VI

THE MONETARY PHENOMENA

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In Keynes view, rising prices in all situations cannot be termed as inflation. In a condition of

under-employment, when an increase in money supply and rising prices are accompanied by the

expansion of output and employment, but when1here are bottlenecks in the economy, an increase

in money supply may cause cost and prices to rise more than the expansion of output and

employment. This may be termed as semi-inflation or reflation till the ceiling of full

employment is reached. Once full employment level is reached, the entire increase in money

supply is reflected simply by the rising prices - the real inflation.

Incidentally, Keynes mentions the following four related terms while discussing the concept of

inflation:

Deflation

Disinflation

Reflation

Stagflation

DEFLATION

It is a condition of falling prices accompanied by a decreasing level of employment, output and

income. Deflation is just the opposite of inflation. Deflation occurs when the total expenditure of

the community is not equal to the existing prices. Consequently, the supply of money decreases

and as a result prices fall. Deflation can also be brought about by direct contractions in spending,

either in the form of a reduction in government spending, personal spending or investment

spending. Deflation has often had the side effect of increasing unemployment in an economy,

since the process often leads to a lower level of demand in the economy. However, each and

every fall in price cannot be called deflation. The process of reversing inflation without either

creating unemployment or reducing output is called disinflation and not deflation. Therefore,

some perceive deflation as an underemployment phenomenon.

DISINFLATION

When prices are falling due to anti-inflationary measures adopted by the authorities, with no

corresponding decline in the existing level of employment, output and income, the result of this is

disinflation. When acute inflation burdens an economy, disinflation is implemented as a cure.

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Disinflation is said to take place when deliberate attempts are made to curtail expenditure of all

sorts to lower prices and money incomes for the benefit of the community.

REFLATION

Reflation is a situation of rising prices, which is deliberately undertaken to relieve a depression.

Reflation is a means of motivating the economy to produce. This is achieved by increasing the

supply of money or in some instances reducing taxes, which is the opposite of disinflation.

Governments can use economic policies such as reducing taxes, changing the supply of money or

adjusting the interest rates; which in turn motivates the country to increase their output. The

situation is described as semi-inflation or reflation.

STAGFLATION

Stagflation is a stagnant economy that is combined with inflation. Basically, when prices are

increasing the economy is deceasing. Some economists believe that there are two main reasons

for stagflation. Firstly, stagflation can occur when an economy is slowed by an unfavourable

supply, such as an increase in the price of oil in an oil importing country, which tends to raise

prices at the same time that it slows the economy by making production less profitable. In the

1970's inflation and recession occurred in different economies at the same time. Basically, what

happened was that there was plenty of liquidity in the system and people were spending money as

quickly as they got it because prices were going up quickly. This gave rise to the second reason

for stagflation.

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